A buyer of an option contract acquires a right to buy a specific property at a specified price within a specified period of time. There are markets for trading in option contracts for currency, commodities, stocks, bonds and other financial instruments. Options trading presents unique problems, and therefore computerized trading of such options over networks accessed by remote users must be tailored for use in options trading.
Banks that provide currency option products to their clients also deal with each other in order to manage currency risk. Currency options in the interbank market are primarily traded between banks on a one-to-one basis (direct market) or are brokered by a currency options broker (broker market).
In the direct market, banks communicate with each other directly. One bank contacts another requesting a price on an option contract that it wishes to buy or sell in order to manage the risk in its portfolio. The bank that is contacted may “make a market” on the option, meaning that it provides both a bid (a price at which it is willing to buy an option contract) and an offer (a price at which it is willing to sell the same option contract) to the bank seeking the price on the option. The bank seeking the price may choose to buy, sell or do nothing. The benefit of the direct market is that a bank may contact many banks and deal with each of them, thus transferring a lot of risk to a number of different banks. The disadvantage is that the bank will have to cross the bid/offer spread (the difference in price between the offer to sell and the bid to buy the same option contract) and will therefore not necessarily find the best price in the market.
In the broker market, the bank seeking a price on an option (referred to as the “Interest”) contacts a broker who in turn makes a market on the option as a result of contacting many other banks. The particular option that the Interest bank wishes to deal is known as the specific-interest. The broker attempts to solicit a price on the specific-interest option from banks called market makers. The broker then assembles the best bid and best offer from the prices obtained from the market makers, and the broker provides this composite price to the Interest. At no stage until a deal is done will anyone except the broker know the identity of either the market maker banks or the Interest. When the Interest sees the price, it may buy or sell or do nothing, or, if it wishes, contribute a better bid or offer to the composite price.
Once the Interest has seen the price and has responded in some way, the broker may then show the price to other banks. These banks may in turn provide better bids and offers inside the price until the bid and offer meet and a deal is made. At this point the broker will identify the counterparties to each other, and, if they are willing to deal with each other from a credit perspective, the remaining economic details of the deal are agreed to and the deal is confirmed. The deal occurs bilaterally between the two banks. The broker is not involved as a principal but acts as an arranger in return for a fee.
One disadvantage of the broker market is that the banks themselves must undertake a final stage of credit checking after a bid and offer are met and after the identity of each party is revealed. The imperfect nature of the credit process can cause problems in a fast-moving market.
All derivatives reference the price of an underlying asset, and in the case of currency options, this asset is foreign exchange spot rate. A disadvantage of the broker market is that market makers are often held to certain option prices when the spot rate of exchange for the underlying currency changes dramatically. Typically, market markers do not like to be held to quoted prices as the spot rate of exchange moves rapidly. This is because the spot price may be “breaking out” of a range, in which case the market perceives options to be cheap and will try to buy them on the market maker's offer, or because the price is drifting back into an old range which can mean that the market is looking to sell. Brokers attempt to protect market makers by not quoting their prices if the spot rate moves dramatically, but this is done on an ad-hoc basis.
Similarly, market makers wish to avoid having stale prices on the market. Brokers try to avoid quoting stale prices, but what is meant by “stale” is generally not clearly defined, and the misunderstandings that arise from this lack of clarity frequently result in prices being withdrawn from the market too soon or too late.
A form of trading that does not go through either the direct or broker markets is so-called “autodealing” or “volatility surface trading.” The prices for puts and calls are often quoted in units of volatility, rather than in monetary terms. Volatility is a measure of the change in value of an option contract which may be calculated if the spot rate, strike price, time to expiry and the foreign currency interest rate and domestic currency interest rate are known. The relationship between these parameters is expressed as the Black-Scholes equation, a universally adopted methodology. After an option contract is bought or sold at a specified volatility, the volatility is converted into a monetary purchase price for the option contract using the Black-Scholes equation. A volatility surface is a three-variable relationship wherein a volatility price can be calculated so long as a given time to expire and given strike price are provided.
Large banks typically provide prices on many option contracts each day, both to traditional clients and to smaller banks. To avoid overloading users with hundreds of pricing requests, many large banks have internally implemented volatility surface trading systems, which allow small trades to be priced automatically. The impetus behind the creation of these systems has been to reduce the manual workload for traders, whose time is quite valuable.
The volatility surface trading system must have or be able to calculate the volatility of any option that is requested. The banks therefore provide a “surface” of volatility, defining the volatility, and thus price, of any option that falls within the defined two-dimensional space of time-to-expiry and strike. This surface is updated throughout the trading day. The normal implementation has been to provide the system with a series of volatilities (hence prices) for commonly traded strikes and tenors. The system can then interpolate according to certain rules a “surface” of volatilities for each desired strike and tenor.
A bank customer who requests an option contract at a particular time-to-expiry and a particular strike price is given an automatic price quote for the transaction in terms of volatility, which is convertible into a monetary price. The rules tend to vary from bank to bank but are broadly similar in general terms. Once the “surface” has been created, it is a relatively simple matter to provide a volatility for any option simply by looking up the correct strike and tenor. Users of the system have the advantages of quick pricing of small specific interests. However, the interpolation of volatility surfaces tend to vary from bank to bank because each bank has a separate set of rules for adopting a surface.
Although banks' interpolation rules are broadly similar, they are different enough to cause economically significant differences in volatilities from different banks for a particular interpolated option. This can lead to arbitrage, wherein market participants take advantage of small price differences in equivalent option contracts, to the detriment of the banks making the market.
Accordingly, an accessible electronic trading system that provides counterparties a means for assuring credit before a deal takes place while maintaining anonymity is desirable. Such a system would also provide market makers with the means, for every price and every currency pair: to define the exact spot price that should result in either a bid or an offer becoming invalid, to automatically withdraw invalid prices, to define a time cut-off for each price, and to automatically withdraw prices at the defined time cut-off. It is also desirable to provide a system that limits arbitrage on volatility surface trading.
The design and implementation of any automatic or computerized trading system is difficult. Designing a system which accounts for the creditworthiness of the buyer and seller users of the system and separately maintains current prices for options is especially difficult since there is a complex relationship between credit worthiness and the acceptable option contract price. Existing electronic or computerized trading systems which are not primarily designed for trading options contain inherent inefficiencies in either or both of these systems components and in the time, cost, resources and price transparency.
U.S. Pat. No. 6,014,627 to Togher et al. describes a computerized trading system dealing with financial instruments such as foreign currency by selectively distributing anonymous price quotes in accordance with pre-established credit limits. The system reviews credit information provided by counterparties using the system and automatically determines whether a predetermined level of credit is currently available from a potential party to a transaction prior to submitting a price quotation to the other potential party based on the information provided. By prescreening bids and offers input by parties, each party is only provided with “dealable” prices from counterparties for which credit compatibility exists. The system is directed to trading foreign currency and not currency options and thus does not provide the more complex system requirements for trading option instruments.
U.S. Pat. No. 5,924,082 to Silverman et al. describes a negotiated matching system that uses a “matching computer” to identify a bid and an offer from suitable counterparties based on transaction data and ranking data supplied by each of the parties. Matched counterparties are then provided a communication link to further negotiate the terms of the transactions.
U.S. Pat. No. 5,787,402 to Potter et al. describes a system for trading currencies in which a user inputs the characteristics of the transaction it desires and the system automatically generates an offer in response to the user's request. The user has a specified amount of time to accept the offer, after which the offer is updated.
U.S. Pat. No. 5,905,974 to Fraser et al. describes a system for automated trading in which bids and offers are displayed on customers' terminal screens. A customer may hit a bid or lift an offer, which initiates transactions at a set price point. The system uses five different trading states in which customers with active bids or offers are given priority to make trades. The system is designed to reward current customers providing active bids and offers.
U.S. Pat. No. 5,832,462 to Midorikawa et al. describes an electronic dealing system that manages credit lines between customers and updates the credit lines as transactions occur between the customers. It also describes grouping a set of customers into a home group for setting a common credit line between the group and another customer.
The trading of options in financial instruments presents varying unique complexities which have not been adequately addressed by the prior art systems such as those discussed above. In addition, the advent of the Internet and related web-based and thin-client-based technologies now provides a platform for the development of a network-based currency option trading system and method, which the present invention addresses.